This column argues that deficiencies in the Eurosystem monetary policy contributed to the “euro crisis”, which is, in reality, an intra-Eurozone balance of payments and external debt crisis. It claims that the Eurosystem’s monetary policy instruments and procedures allowed intra-Eurozone external imbalances to accumulate since the start of the third phase of the EMU in January 1, 1999. As a result, though the Eurozone has low levels of net external debt relative to its GDP, it presently confronts, in its midst, what is likely the largest peacetime external debt crisis the World has ever seen (Das et al., 2012; Reinhart et al., 2003). Moreover, it points out that the Eurosystem’s monetary policy has always had large fiscal effects and currently results in financial transfers from Eurozone creditor countries (the GNLF) to Eurozone debtor countries (the GIIPS) that may amount to 1.3% of the GIIPS’ combined GDP per year.
The Debate on the Euro Crisis
Since 2008, capital flight from the GIIPS, driven mainly by the banking sector, has led to a pronounced rise in the Eurosystem’s TARGET2 imbalances (Figure 1), which translate into large imbalances in the net external debt position of Eurozone NCBs (Table 1).
Figure 1: TARGET2 Imbalances (Chart from Institute of Empirical Economic Research – Universität Osnabrück)
Table 1: Total, Banking, and Central Bank Net External Debt (+/- for net debtor/creditor)
Sinn (2011) and Sinn and Wollmershäuser (2012) argued that there was a link between TARGET2 imbalances and (cumulative) current account deficits of the GIPS and that TARGET2 funding of the GIPS’ central banks represented a “stealth bailout” by the Eurosystem. They also pointed out that the Bundesbank faced the risk of large losses on its claims vis-à-vis TARGET2 should there be a euro breakup (Whelan, 2012; De Grauwe and Ji, 2012).
In response to Sinn, Whelan (2011) and Buiter et al. (2011), among others, argued that the rise in TARGET2 balances likely simply reflected private-sector capital flight.
Gros and Mayer (2012) looked at the causes of those TARGET2 imbalances, i.e., at what explained the high current account deficits in the first place. They noted the rise in German surplus savings from the historical 1%-2% of GDP to 6% of GDP since the introduction of the euro. They argued that the introduction of the euro led German banks to believe that exchange rate risk was gone and to channel German surplus savings to the GIIPS countries.
After 2008, German banks realized that exchange rate risk had not disappeared and refused to rollover loans (Dor, 2012), which explains the capital flight and the growth in TARGET2 imbalances (Table 1).
The Role of Monetary Policy in the Eurozone’s Balance of Payments and External Debt Crisis
This column argues that flaws in the design of the Eurosystem monetary policy instruments and procedures played a larger role in the GNLF banks’ lending to the GIIPS banks (Figure 2) – and to the euro crisis – than the elimination of exchange rate risk:
- The Eurosystem monetary policy instruments reduced the credit risk of Eurozone banks. Banks could, if necessary, obtain liquidity by using a wide range of financial assets as collateral in the Eurosystem main refinancing operations transactions. This means that inter-bank lending became less risky.
- GNLF banks did not need to have GNLF families’ deposits to lend abroad. Credit money creation is endogenous (Moore, 1979; Borio and Disyatat, 2010; Cabral, 2012). Banks create deposits as they make loans, which they can do as long as they have sufficient excess reserves (and capital ratios above minimum requirements). GNLF banks used their excess reserves to lend to the GIIPS banks or to buy the GIIPS’ corporate and public debt. GNLF banks could then use this GIIPS’ debt as collateral in the Eurosystem reverse transactions (and in the private repo market) to obtain further liquidity (excess reserves) in order to extend additional loans. This process could be repeated over and over again.
- A substantial portion of the GIIPS’ domestic financial assets could be used as collateral in the Eurosystem’s liquidity providing operations (Fels, 2005; Buiter and Sibert, 2005). Thus, the Eurosystem’s monetary policy instruments, by increasing the acceptability of the GIIPS countries’ financial assets, weakened balance of payments constraints (Pivetti, 1998; Andini and Cabral, 2012) and meant that the large and recurring GIIPS’ current account deficits could be financed for far longer than would have otherwise been possible.
- That is, the Eurosystem’s monetary policy design facilitated the growth in the GIIPS countries’ net external debt to unprecedented levels (Table 1).
Figures 2a and 2b: German Banks’ Claims on GIIPS’ Banks (2b: marked as private risks) and Bundesbank TARGET2 Claims (2b: marked as Public risks) (Charts from Carmel Asset Management).
The Fiscal Effects of the Eurosystem’s Monetary Policy
The Eurosystem’s main monetary policy instruments differed from central bank best practice (Buiter and Sibert, 2005; Hamilton, 2008; Cheun et al., 2009).
In fact, traditionally, central banks essentially managed the composition of public liabilities: central bank liquidity providing operations either acquired outright or required the delivery of sovereign debt (or agency debt) as collateral against the provision of currency (Hamilton, 2008; Cheun et al., 2009). Thus, traditional liquidity providing operations did not materially increase net public liabilities, since they consisted in replacing private sector holdings of sovereign debt (a form of public liabilities) with currency (another form of public liabilities).
This was the modus operandi of, for example, the Federal Reserve prior to 2007 (Cheun et al., 2009).
However, the ECB decided to accept a broad range of private and public debt securities as collateral in the context of the Eurosystem’s temporary liquidity providing operations (ECB, 1998), which were much larger than those of the Federal Reserve.
As a result of this choice by ECB policy makers, the Eurosystem’s monetary policy has very large fiscal effects (MacKenzie and Stella, 1996) because:
- The Eurosystem’s refinancing operations with private sector debt collateral and outright purchases of private sector debt in the secondary market increase net public liabilities (temporarily and outright, respectively). This is done without prior authorization by the European Parliament or by the National Parliaments;
- In addition, with the traditional monetary policy instruments format, if a counterparty (i.e., a bank) failed and could not return a loan, the central bank could hold on to the collateral – the sovereign debt. This means that the failure of a monetary authority counterparty resulted only in a change in the composition of public liabilities: more currency but less sovereign debt held by the private sector (Hamilton, 2008). In contrast, the Eurosystem’s monetary policy operations create a loss risk to the taxpayer. This occurs because some of the collateral may be private sector debt, which may not fully cover the outstanding loan;
- The Eurosystem monetary policy – like fiscal policy – has large redistributive effects. It benefits Eurosystem counterparties, which thus gain a competitive advantage. For example, on the one hand, banks and several corporations with bank subsidiaries are able to obtain loans from the Eurosystem at much lower rates than their own market funding costs. On the other hand, these Eurosystem counterparties benefit from an unlimited deposit guarantee over the totality of their deposits with the Eurosystem;
- The Eurosystem also accepts non-sovereign public debt as collateral, specifically, debt securities of various Eurozone public sector entities (including local and regional governments). This feature of the Eurosystem’s monetary policy instruments and procedures likely weakened national controls on public spending. Private sector banks were likely more willing to finance a part of the public sector entities borrowing in the knowledge that they could refinance it with the Eurosystem;
- Finally, in a country or a federation of states, financial transfers between regions are implemented through fiscal policy. In contrast, in the Eurozone, these transfers have, to a large extent, been accomplished through monetary policy. Presently, this occurs through TARGET2 lending between Eurozone current account surplus and deficit countries’ NCBs, at subsidized interest rates (Table 1). As of July 2012, the GIIPS’ large – structural – TARGET2 balances represented approximately 31% of the GIIPS’ combined GDP (Figure 1). In the 12 months ending in July 2012, these balances grew at approximately 1.6% of the GIIPS’ combined GDP per month (i.e., by €52 bn per month).
On the one hand, the TARGET2 funding results in lower balance of income deficits for the countries whose NCBs have large TARGET2 liabilities (Cabral, 2011) because the interest rate on TARGET2 balances – currently at 0.75% – is much lower than market interest rates. In fact, the interest subsidy on the GIIPS’ TARGET2 outstanding liabilities currently may represent 1.3% of the GIIPS’ combined GDP per year. That is, the interest subsidy on TARGET2 balances is equivalent to a large fiscal transfer from the GNLF countries to the GIIPS countries.
On the other hand, several of the GIIPS countries will have to restructure their (external) debt in the future (Cabral, 2010). This includes their NCB’s outstanding TARGET2 liabilities, which represent a growing share of these countries’ net external debt. Future losses on this Eurosystem lending would be equivalent to a de facto fiscal transfer above and beyond the interest subsidy identified above.
The Eurosystem monetary policy strategy, instruments, and procedures have contributed to an unprecedented intra-Eurozone external debt crisis and presently result in large “stealth” transfers from the GNLF to the GIIPS, among other fiscal effects.
Therefore, in responding to the euro crisis, one important step forward lies in addressing the deficiencies in the Eurosystem monetary policy. In my view, this could be accomplished through measures that reduce the presence of the Eurosystem in financial intermediation. In short, the Eurosystem, in its liquidity providing operations, should only accept as collateral sovereign debt of Eurozone member countries. Moreover, open market operations should be based almost exclusively on outright operations on the sovereign debt of Eurozone member countries. These could be conducted on the basis of the ECB adjusted capital key. Temporary refinancing operations should be slowly winded down, and ultimately removed altogether from the monetary policy toolkit of the Eurosystem.
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 Eurosystem: European Central Bank (ECB) and Eurozone member states National Central Banks (NCBs).
 EMU: Economic and Monetary Union.
 Most monetary policy interactions with private-sector counterparties (qualified financial institutions) have effects equivalent to granting subsidies or raising taxes, i.e., central bank operations have quasi-fiscal effects (Mackenzie and Stella, 1996). The point I make in this column is that the fiscal effects of traditional central banking were relatively small. In contrast, I argue that with the Eurosystem monetary policy strategy, instruments, and procedures, the fiscal effects of monetary policy became very large, i.e., are no longer simply quasi-fiscal.
 GNLF: Germany, Netherlands, Luxembourg, Finland; GIIPS: Greece, Italy, Ireland, Portugal, and Spain; GIPS: Greece, Ireland, Portugal, and Spain.
 TARGET2: Trans-European Automated Real-time Gross settlement Express Transfer system, 2nd generation, owned and operated by the Eurosystem. TARGET2 is the Eurozone’s payments system.
 NCB: National Central Bank, referring to the Central Bank of a Eurozone member country.
 The methodology used by central banks and statistical offices to determine International Investment Position (IIP) statistics assess the value of a particular position on the basis of its market price. Particularly after 2009, the market prices of the GIIPS’ public and private debt fell markedly. Thus, the IIP statistics became a less reliable indicator of these countries net external debt. For example, Portugal registered large current account deficits in 2010 and 2011, but was able to report an improving net external debt position between 2009 and 2011. This occurred in no small part because of valuation effects. The market price of some of Portugal’s 10-year sovereign debt declined over time to about 40% of its face value by February 2012. The market prices of private sector debt securities (particularly bank debt) also fell markedly in this period. Thus, the improvement of Portugal’s net external debt position between 2009 and 2011 is illusory. The nominal value of its net external debt most likely increased in this period.
 Sinn (2011) argues that TARGET2 funding was used to finance current account deficits after 2008. De Grauwe and Ji (2012) show that there is no correlation between the rise in TARGET2 imbalances after 2008 and current account deficits in that period. Instead, they argue that TARGET2 imbalances have increased mainly as a result of speculative flows. However, in my view, these two theses are not mutually exclusive: current account deficits were in the past financed by the private sector (mainly banks). Heightened fear led to capital flight mainly by private sector banks in the GNLF (Table 1). Figure 2b and Table 1 suggest that a large part of increase in the Bundesbank claims vis-à-vis TARGET2 occurs as the German banking system reduces its claims vis-à-vis the GIPS and the rest of the world, respectively (Dor, 2012). That is, TARGET2 imbalances are likely, to a large extent, a consequence of accumulated current account imbalances, even if the two variables are not linearly correlated.
 The Eurosystem’s collateral rules likely contributed to increase the acceptability of the GIIPS debt as collateral in private-sector repo market transactions.
 Net public liabilities are hereafter defined as gross public liabilities less public liabilities held temporarily or outright by the monetary authority.
 Article 18.2 of the Statutes of the ECB, annexed to the European Union Treaty, states that “The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.”
 In contrast, government expenditure is subject to prior authorization by the National Parliaments.
 In fact, in 2008 the Eurosystem registered losses from the bankruptcy of the main Icelandic banks and of Lehman Brothers (Sibert, 2010; Ewing, 2012).
 To a large extent, the GIIPS banks seem to have used the Eurosystem (and in some cases Emergency Liquidity Assistance) funds obtained via respective NCB and TARGET2 to replace external debt owed to foreign financial institutions (Whelan, 2011; Dor, 2012). The GIIPS banks’ would have to pay much higher interest rates if they borrowed funds in the market, rather than through the Eurosystem. Thus, from the GIIPS banks’ but also from the GIIPS countries’ perspective, it is preferable to fund these liabilities through the Eurosystem because of the much lower interest rate. Since TARGET2 balances are so large relative to GDP, the interest cost savings translate into improved balances of incomes for the countries with high TARGET2 liabilities. Large TARGET2 funding also result in lower GIIPS governments’ budget deficits, ceteris paribus (Cabral, 2011).
 Assuming a 5% average market interest rate for loans collateralized with the GIIPS countries’ financial assets.